Who Loses Because of the Settlement? We All Lose!


New York, NY – Recently we wrote a ResearchWatch article which tried to address the consequences of ending the Global Research Analyst Settlement next summer. As you might guess, this topic raises a great deal of debate as some readers see the Settlement as an initiative which protected retail investors from the biases of investment banks, while others feel the Settlement was overreaching and it created more harm than good. The following is a well reasoned article written by an anonymous industry observer which takes the latter viewpoint.

The major negative impact of the Global Research Analyst Settlement will be on US capital markets, the costs of which all of us will bear for a long time.

Based on the stupid actions of some prominent analysts and some of the people to whom they reported, the regulators, led by a politically ambitious Attorney General in New York, argued successfully that sweeping structural changes (e.g., the separation of investment banking from investment research) were necessary “to restore faith in the system” and “to protect the small investor.” The investment banks were bludgeoned into accepting these changes under threats by Spitzer of jail time for senior executives. He was able to make these threats because the 1921 Martin Act in the State of NY provides an extremely broad definition of fraud and extremely broad investigative (read: “intimidation”) powers.

Critics of the GRAS argue that: (a) there are no “small investors” to protect because all investors are savvy enough to know that every research report is biased in some way (even the quantitative ones); (b) the problem of misleading research is self-correcting because any IB (or any analyst within an IB) that produces research that “burns” its clients destroys its own brand and soon goes out of business because no one will pay for its research or buy its deals; and (c) any benefits from trying to legislate morality (i.e., to structurally eliminate investment banking bias in sell-side research) are vastly outweighed by the costs of trying to do so.

The major cost is reduced market efficiency, which means greater volatility and a higher cost of capital to US companies, which means that US companies (and US exchanges) are less competitive in world markets, and that their overall benefit to our society is less than it could have been.

Market efficiency is reduced because the market is not as well informed or as liquid as it would have been without the GRAS. Thus, it cannot adjust as quickly and accurately to the stream of developments that constantly change the prospects for and risk characteristics of individual companies and the overall economy.

The market is unable to adjust as quickly and accurately because the quantity and quality of sell-side research has declined because there are fewer analysts, lower quality analysts, less effective research departments, fewer companies under coverage, and hence less information in the public domain about expectations for earnings and stock price performance.

The reduced quantity of sell-side analysts and the reduced number of companies under coverage have been well documented.

Quality is down because, having been excluded from the professional challenges and economic rewards of successful investment banking activities, the best and brightest sell-side analysts have defected to the buy side, particularly to hedge funds and private equity funds where they can obtain a much higher return on their skills and knowledge, and where, ironically, the opportunities are greatest to exploit the very market inefficiencies that are attributable in part to their defections.

Quality is also down because, ceteris paribus, analysts involved in investment banking activities are better analysts than those who are not. Investment banking provides access to information, opinions and dialogs that enhance the quality of investment research. Information flow between IB and research is a good thing, not a bad thing, subject to obvious constraints like those on material nonpublic information.

In short, the quality of the amorphous but critically important intellectual framework within which market participants collectively and constantly re-price capital assets has been degraded by the misguided structural reforms imposed by the GRAS on the IB industry.

If they felt compelled to do something, the regulators should have simply imposed greater oversight of potential bias in investment research rather than imposing sweeping structural reforms. If the regulators’ logic in this case were applied to other potential abuses in our society, instead of arresting and punishing criminals, we would assume that everyone is a potential criminal and put all of us under constant surveillance in an Orwellian police state.

The important lesson we should draw from this experience is that, just as one cannot today construct a major new building or plant without a comprehensive Environmental Impact Study, regulators should not be allowed to impose any new rules or requirements without having first completed a comprehensive study of the direct and indirect effects of their proposed actions.

As for the Independent Research provisions of the GRAS, the data suggest strongly that IR has simply not been used by investors. This should not surprise anyone given that all twelve firms under the Settlement provide full-service brokerage operations, and the investors who use such services do so precisely because they do not want to do their own research and make their own investment decisions. Private investors who do their own research do not trade through a full-service broker; they trade through such discount brokers as eTrade and Schwab. The cost of each independent research report that has actually been accessed by “retail investors” at the twelve Settlement banks has been astronomical.

In the long run, US market efficiency may benefit from a re-emergence of small IB boutiques that are not subject to the restrictions imposed by the GRAS, where investment bankers and investment analysts can work closely together for the benefit of their ultimate clients, the investors who buy their research and deals.
– by An Industry Observer


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